When you sell inventory, the result is reported currently as ordinary income. You can’t exclude the income and you can’t defer it. When you sell business property at a profit, it usually results in a capital gain. In a handful of situations, you can exclude the gain; it’s not taxable. But generally, gain is recognized and taxed in the year of the sale. Still, there are some good ways to postpone tax on the gain. Consider these options before you finalize any sale so you can be positioned to take advantage of a particular deferral option.
Benefits of deferral
Tax deferral means you’re pushing off the time when taxes need to be paid. In inflationary times, this translates into paying taxes in the future with inflated dollars, effectively costing you less.
Deferral can also mean you benefit from cash flow; it depends on the situation. You may get your money from the sale now, but it’s not depleted by taxes until they’re paid in the future.
An installment sale results when you receive at least one payment from the sale in the year after the sale. Typically, installment sales spread out the payments over a number of years—5, 10, or even more. For tax purposes, you pay tax on the portion of gain related to the installment payment received. In broad strokes, if you sell something for $10,000 and receive a payment of $2,000 each year for 5 years, then 20% of the gain is taxed each year that the payment is received.
There are some downsides to an installment sale to consider:
- If the property sold is subject to depreciation recapture, gain related to the recapture must be reported in full in the year of the sale, regardless of the fact that some or all of the proceeds will be received in the future.
- Spreading payments over a number of years means you have to wait for your money. If you intended to do something with that money now, this may weigh against doing an installment sale.
- There’s a risk that the buyer may default. Yes, you can probably recoup your property through legal action. But this involves time and cost, and having to dispose of the property again.
- Not all types of business property qualify for installment sale treatment.
You can learn more about installment sale reporting from IRS Publication 537.
Deferral of gain on small business stock
Gain on the sale of qualified small business stock (QSBS) acquired after September 27, 2010, and held more than 5 years is 100% tax free (there’s a $10 million limit). But what if you didn’t hold the stock that long? In this case, you may elect to defer gain if you reinvest the proceeds from the sale of the original QSBS into other QSBS within 60 days.
QSBS must satisfy various conditions listed in Section 1202 of the Internal Revenue Code. These are the same conditions applicable for the exclusion, other than the 5+ year holding period.
The deferral election is made on your tax return, Form 8949, simply by entering code “R” in column (f) and the postponed gain as a negative number in column (g). Nothing else has to be filed, but keep all documentation supporting the sale and reinvestment.
Deferral of gain through Opportunity Fund investments
Capital gains, as well as “Section 1231 gains” on certain business property, can be deferred by reinvesting proceeds in a Qualified Opportunity Fund (QOF) within 180 days of the date of the sale. The deferred gain will be recognized on the earlier of sale of your interest in the fund or December 31, 2026. There’s no dollar limit on the amount that can be deferred.
There are additional benefits:
- If you hold your investment in the QOF for at least 5 years, the basis in your interest in the fund will increase by 10% of the deferred gain.
- If you hold your investment in the QOF for at least 7 years, the basis in the fund will increase by an additional 5% of the deferred gain.
- If you hold your investment in the QOF for at least 10 years, you can permanently exclude gain when your QOF interest is sold as long as you elect to increase the basis in your QOF to its fair market value on the date of the original sale.
Find more information about this deferral option from the IRS.
Deferring gain on involuntary conversions
If you suffer a casualty—a fire, hurricane, or other similar event—that damages or destroys business property, or there’s a theft or condemnation, insurance proceeds may result in your having a tax gain despite your economic loss. That’s because you reduced the tax basis of the property through depreciation or other first-year write-off, while the proceeds more closely reflect the value of the property at the time it went through the destructive event.
You can elect to postpone recognizing the gain if you timely reinvest in replacement property. The replacement period usually ends 2 years after the close of the first tax year in which any part of your gain is realized. It’s 3 years for realty held in a trade or business. And it’s 4 years or longer for livestock sold because of drought. Replacement property is property that’s similar or related in service or use (i.e., substantially similar to the old property). An example is the replacement of destroyed facilities on leased land in one location by the construction of similar facilities on leased land in another location.
For more information, see IRS Publication 547 (look for “Postponement of Gain”).
These are not the only situations in which deferral is possible. For example, like-kind exchanges of real property push the tax bill forward. Because deferral rules can be varied and complicated, be sure to work with a knowledgeable tax pro so you get things right.